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October 20, 2009 - Strong dollar a threat, central bank says
Strong dollar a threat, central bank says
Kevin Carmichael, Globe and Mail Update
Ottawa — The Canadian dollar's race toward parity risks “more than fully” offsetting the benefits from a surprisingly strong recovery from recession, the Bank of Canada said Tuesday.
Explaining their decision to leave the benchmark interest rate at a record low of 0.25 per cent, policy makers said the loonie's ascent to levels around 97 cents (U.S.) in recent weeks is hurting Canadian exporters' ability to participate in a global economic rebound that is stronger than they expected it would be in July.
So even though a “recovery in economic activity is also under way in Canada,” policy makers actually pushed back their outlook for when inflation will return to the central bank's target of 2 per cent to the third quarter of 2011. The reason is the dollar, which is making Canadian goods more expensive in the U.S., the country's largest trading partner, and in international markets that tend to price in U.S. dollars.
“Heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures,” the Bank of Canada said in a statement. “The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July.”
The central bank's latest policy statement raises the likelihood that the central bank will stick to its pledge to leave its key overnight target at 0.25 per cent until June 2010, and could stoke speculation that Governor Mark Carney will opt to leaver interest rates near zero for even longer.
That's because the pledge is conditional on the central bank's outlook for inflation, which it is mandated by law to keep at an annual rate of about 2 per cent. The latest inflation figures show consumer prices are actually declining, meaning the central bank has to find a way to stimulate growth to put upward pressure on prices.
“The greater persistence of slack in the economy, and attendant downward pressure on inflation, provide more reason for the Bank of Canada to delay rather than advance any tightening in policy,” Paul Ferlely, Royal Bank of Canada's assistant chief economist, said in a note to clients.
If not for the dollar's ascent, Canada's recovery would be much stronger.
The central bank said global and financial developments have been “somewhat more favourable than expected” since their last quarterly economic report in July.
At home, the economy is getting a lift from low interest rates and government stimulus spending, increased household wealth, improving financial conditions, higher commodity prices and strong business and consumer confidence, the Bank of Canada said.
Nevertheless, the stronger currency is robbing Canada of wealth generated from exports, leaving the country's economy to operate on one engine.
“The composition of aggregate demand will shift further toward final domestic demand and away from net exports,” the central bank said.
For the short term, gross domestic product will grow faster than the central bank expected. Policy makers said growth in the second half will be “slightly higher” in the second half than previously thought, although they didn't provide a figure.
However, over the next couple of years, growth will be lower than predicted in July. Canada's economy is expected to expand by 3 per cent in 2010, which is unchanged from three months ago, and 3.3 per cent in 2011, which is lower than the previous forecast of 3.5 per cent.
The loonie fell more than a cent after the Bank of Canada's release, tumbling to about 96 cents (U.S.) from 97.15 at 4.30 p.m. (EDT) yesterday, which is when the central allocates a closing value.
The comments on the dollar were the strongest yet in a verbal campaign that dates back to early June, when the Bank of Canada first raised concern that the currency could impede the recovery.
Mr. Carney's efforts to keep speculators guessing about whether the central bank will intervene is some way to make the Canadian dollar a less profitable trade have had some success at slowing the currency's rise.
However, lately, the loonie had appeared to have come untethered. The currency has gained about 5 per cent since the central bank's last economic report on July 23, most of that in the last couple of weeks, as global investors become more confident about the rebound and seek better yields than are on offer in the U.S.
The central bank's downward revision of Canada's longer term growth prospects suggests policy makers suspect the loonie's increase as more to do with speculators than fundamental factors such as higher commodity prices, said Michael Gregory, a senior economist at BMO Nesbitt Burns in Toronto.
When the dollar is rising along with increases in the price of commodities, the net effect on the economy is less severe, if not a wash. A gain driven mostly by speculative pressures has a net negative impact on growth, according to the central back.
By pushing out its inflation forecast, traders may begin to bet that interest rates will stay low in Canada longer than they thought, making jurisdictions where central banks are raising interest rates, such as Australia, more attractive.
Before today's announcement, some investors were betting the Bank of Canada would raise interest rates early in 2010, according to futures contracts whose yields are based on future interest rate expectations.
The changed inflation outlook “makes it incrementally easier for the Bank to stick to its commitment” to keep the benchmark lending rate at 0.25 per cent until June, Mr. Gregory said in a report to his clients.
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